Solvency II boosts appetite for sovereigns and credit, says AXA study

Solvency II has pushed up the price of corporate bonds, according to a study by AXA Investment Managers, creating a greater appetite for sovereigns and credit.

The upcoming Solvency II regulation has caused European insurers to shift their asset allocation to reflect asset class volatility and solvency capital requirements (SCR). Investment grade credit becomes the defensive asset of choice because of its lower volatility and acceptable SCR level.

This has resulted in a shift of some €500bn of their assets away from equities in favour of less volatile, short-term fixed income assets.

“Solvency II has contributed to low European equity price levels and has put cumulative downward pressure of 80bps on corporate bond spreads since 2009. Its impact on govies has been insignificant,” the study says.

As a result, the study says, the market has seen “greater appetite for sovereign debt, as it is not SCR charged. This tendency is further boosted by local rules and regulations that encourage the uptake of domestic sovereign debt.” One is example is the Italian government’s Salva Crisi decree, promoting Italian government bonds (BTPs).

The shift in asset allocation has other implications, says the study. The reallocation will cause investors to seek greater diversification in order to reduce capital requirements and lower economic volatility; investors will increase their use of derivatives to dynamically manage risk in interest rates and equities; and they will be under pressure to shift the hedging strategy on long-dated liabilities away from the long end of the interest rate curve in light of the Ultimate Forward Rate (a fixed long-term rate for discounting liabilities).

The study’s authors, Mathieu L’Hoir and Mathilde Sauve from AXA Investment Managers’ Research and Investment Strategy team, say the shift in asset allocation, has already had an impact. The shift “may explain up to 25% of the current gap in equity prices with respect to pre-crisis levels, and will continue to impact European equity and fixed income markets in coming years.”

The Solvency II Directive is due to come into effect on 1 January 2015, though implementation may not be until the following year. The Directive is a risk-based framework for the European insurance industry that includes a new set of capital requirements and valuation techniques with respect to investments. 

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